Fund managers who make use of ‘indexation’ try to find more structured and ‘rules-based’ ways to invest. This is in contrast to the more ‘active’ management styles where fund managers seek to generate outperformance by picking certain stocks, bonds and other financial instruments based on their current and expected valuations.
A fund manager who adopts an ‘active’ style of investment management evaluates specific stocks, bonds and other financial instruments – and invests only in the instruments that they feel are going to outperform the market or benchmark (in other words generate alpha) whilst avoiding the rest.
A fund manager who subscribes to ‘indexation’ on the other hand, believes that the market in general is a better predictor of future performance than trying to pick the outperforming stocks. They use certain rules and algorithms to set up portfolios in a way that minimize the need for analysis and therefore reduce the risk of human error and biases within the portfolio.
In this article, we will explore the different definitions and concepts within the indexation investment strategy and how the strategy differs from the ways general active fund managers invest.
[For reference: It is common in the industry to use ‘passive investing’ and ‘indexation’ interchangeably. But for the context of this piece, we will use ‘passive’ to define one of many types of indexation investing to simplify the explanation.]
The key differences between ‘active’ investing and ‘indexation’:
The first glaring difference between the two types of investing is the fees. This is mainly due to the amount of research and analysis that goes into actively picking stocks and investment instruments. It is therefore important to weigh up the factors when choosing how much of a portfolio to allocate to indexation and how much to allocate to active managers. Lower fees do not necessarily imply higher returns, but a combination in allocation should see your average portfolio Total Investment Cost [TIC] come down considerably.
- Tracking Error
Tracking error is the degree to which a portfolio mimics the holdings and returns of a benchmark. A high tracking error means that the portfolio holds a very different allocation of instruments compared to the benchmark (or market) and therefore generally has varying returns as well.
Indexation portfolios generally have a very low tracking error where active portfolios could have very high tracking errors. Once again, a combination between the two strategies provides a diversification benefit versus choosing one or the other.
- Valuations versus rules
The obvious difference between these investment philosophies is the way in which the portfolios are constructed. ‘Active managers’ would use various analytical techniques to evaluate the value of a specific stock or bond and use that information to decide how much (if any) of that instrument to include into their portfolio. ‘Indexation managers’ would create a set of rules (or follow a specific benchmark) and only change the portfolio in line with what the rules (or benchmark) dictate.
Types of Indexation
When looking at the different types of indexation, there is a lot of ground to cover. For now, we will provide a basic definition of these concepts with the view to expand on them in the future.
- Passive (Beta)
‘Beta’ is jargon for ‘market’ or ‘benchmark’ returns. Many indexation managers mimic a specific market or index with minimal tracking error. The experience of the clients within the portfolio is reliable returns (vs the benchmark) that can be easily explained by market movements. This is in contrast with an active manager, that will deviate from the market holdings and returns in an effort to outperform, this is called Alpha.
The most popular Beta indexes include the ALSI Index, SWIX, ALBI, DIVI, RESI and capped versions of these.
- Smart Beta
Smart Beta is a style of indexation that uses Beta (or benchmark) as the core of the portfolio. The portfolio manager can then make slight ‘tweaks’ in the asset allocation and/or instrument allocation to try and outperform that specific benchmark. The methodology used by the portfolio manager to determine over- or under-weighting of instruments is up to their discretion and can be anything from single stock picks to an arithmetic based algorithm.
- Factor Investing
Factor investing has become very popular in the last five years. The concept of factor investing is that, within the equity portion of the portfolio, the portfolio manager invests into certain ‘factors’ of the market. The most widely used factors are Growth, Value and Momentum. Although there are many other ‘factors’ that portfolio managers can use, these are by far the most popular.
The idea here is that the portfolio manager creates a ‘basket’ of equities that they define within each factor. They then decide how much to allocate to each of the factors or factor weightings. Many variations on this base example exist, so it is important to ensure the following:
- The definitions of each factor
- How each factor is constructed
- The methodology in deciding the weightings of each factor within the portfolio
- Themed Indexation
A type of indexation that is gaining a lot of traction is themed indexation. This is like factor investing in that a ‘basket’ of stocks is created and then weighted but differs in definition and construction. With themed indexation, the portfolio manager creates a basket of stocks based on a specific theme that they feel should outperform or that they have expert knowledge in. Themes can be anything from ESG and environmental themes to a more specific focus like automotive technology and agriculture.
It is clear that what some still call ‘passive’ investing, is anything but passive. There are many ways to combine skill and algorithms to change a portfolio in ways to create value for investors. It is very important, however, to understand the methodology behind the fund manager’s choices. Both active and indexation managers have their advantages within an investment framework, depending on what you want to achieve within the portfolio.